Central banks: towards a policy of “small steps”

05.17.2023 2 min
Read my column published in the 17th of May 2023 issue of Les Echos.

The global economy is slowing. This will complicate the situation of highly indebted governments and private players. But in principle it should facilitate disinflation, thus slowing the rise in interest rates and possibly facilitating their subsequent decline. However, activity is holding up better than expected and labour markets continue to be tight – high employment rates and low unemployment rates – which is maintaining the level of core inflation. This is consequently accompanied by very low or even zero productivity gains.

Monetary policies are therefore set to continue with their interest rate hikes, albeit with great caution. And at least maintain this level of interest rates, for longer than was expected by the financial markets. There are many reasons for this necessary caution. The new financial conditions have tightened, which in itself results in a slowdown in credit and the economy. Interest rates are therefore higher, risk premiums (“spreads”) larger, lending conditions more stringent, liquidity less abundant, etc. Further monetary policy tightening is therefore not necessarily required. Small steps will now be key, with a study of all the available data between each decision, so as not to do too much or too little.

But above all, the vulnerabilities of the financial system as a whole are obviously what has made central banks very cautious. Of course, the recent signs of this instability had partially idiosyncratic causes. Silicon Valley Bank was poorly managed and under-supervised. The simultaneous increase in the number of cases and the resulting contagion nevertheless show the potentially systemic nature of these events. Long-term rates too low for too long have made many balance sheets highly vulnerable. On the liabilities side, because many companies and governments, and even individuals, both in advanced and emerging countries, were able to take on debt without apparent pain, up to the point of over-indebtedness with a normalisation of interest rates. On the assets side, because in order to seek a little yield in times of zero or even negative interest rates, end investors, either directly or through various asset managers, were encouraged to take more and more risks, whether by extending the maturities of the assets purchased, by a greater dissymmetry between the duration of assets and of liabilities, by accepting higher credit or equity risks, by increasing leverage, etc. The rapid rise in interest rates marked an abrupt break from this long period of rates that were too low (i.e. below the growth rate), during which these weaknesses accumulated. Today, the large global real estate bubbles appear increasingly vulnerable, and the fall of the equity markets will be even greater if they continue to ignore the gradual effects of the general tightening of financial conditions. And the risk of insolvency of many highly indebted players has risen sharply.

Central banks are very aware of this situation, such as the risks generated by a very tense geopolitical situation, leading to, among other things, a costly fragmentation of economic zones. And although on average banks are much stronger than during the big financial crisis, with shadow banking remaining much less regulated, monetary policy authorities will double down on caution, but will preserve their indispensable credibility in their fight against inflation.

Olivier Klein
CEO of BRED and Professor of Financial Macroeconomics and of Monetary Policy at HEC Paris